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Five Lessons from the Allowance for Loan Losses

Trends as well as theory drive the management of the ALL balance.

The process of building ALL reserves has been painful for the industry. In a year where earnings have been signifi­cantly impacted by rebuilding the National Credit Union Share Insurance Fund, and large losses recognized by many credit unions in the write-off of their corporate credit union deposits, provision for loan loss charges for amounts never before imagined were also recognized by most credit unions. Auditors, examiners, CFOs, and others charged with a governance role over the ALL have learned many important lessons during this severe economic cycle, the most critical of which are summarized below.

Lesson 1

In the past, most credit unions relied solely upon histori­cal loss ratios to calculate the balance of their ALL. Because historical loss ratios are probably not reflective of current loss trends, their use alone will probably result in erroneous allowance balances. The historical loss ratios must be supple­mented with other tools, most notably the use of what are referred to as qualitative and environmental (Q&E) factors.

Lesson 2

Troubled-Debt Restructures (TDRs) require specialized accounting procedures. Prior to the current economic cycle, it was rare for credit unions to have material amounts of TDRs. Not so today. Many credit unions have been approv­ing restructured loans, but not appropriately accounting for these loans, and also not properly reporting these loans for regulatory purposes. Problems encountered include failure to recognize and communicate TDRs to the accounting staff, failure to consider the possibility of re-default, and improper accounting and reporting subsequent to the restructure. The financial accounting impact of a TDR can be significant and therefore can’t be ignored. If your credit union is routinely approving restructured terms on consumer (non real estate) loans, TDR accounting might be required.

Lesson 3

There has been a failure to update or modify the ALL policy and to modify ALL methods to reflect the significant economic changes of the past few years. Be prepared to discuss your ALL balance with your auditors and examin­ers, and be prepared to be challenged as to the “not enough” attitude. The best way to defend your balance is to steer the conversation away from the amount of the ALL and to dis­cuss the approach and methodology utilized that produced the answer. If you focus the conversation on approach and methodology and have a well articulated ALL policy in writ­ing and approved by the Board, you’ll have a much better chance of winning the challenge. Every credit union should have an updated ALL policy, which has been approved by the Board of Directors and is reviewed on an annual basis for appropriateness in the current environment.

Lesson 4

Too many credit unions have not involved their chief lending officer and chief collection officer in the ALL discussion and analysis. Their CFOs have accepted full responsibility and often these other management folks are not grounded in ALL theory. This is bad policy and will probably contribute to an ALL error. The best process will include extensive discussion among all the parties involved in the lending management. Further, a process should be implemented that provides an overview of the ALL meth­ods and ALL outlook to the members of the Board of Directors and Supervisory Committee every year.

Lesson 5

Too much in the ALL is not conservative, it is just bad accounting. U.S. GAAP operates in what is called an “incurred loss” model. We don’t recognize loan loss expense to cover circumstances that have not yet occurred. Nor can we ignore impairment on loans which haven’t yet been specifically identified but are likely impaired.

Important lessons on ALL adequacy can be ascertained from large public banking companies whose ALL balances are scrutinized by the SEC and investment community. Often, ALL adequacy is measured in terms of forecasted charge-offs for the next 12-month period. In a Wall Street Journal article on November 2, the following data was pub­lished reflecting the relationship between the ALL versus estimated credit losses for the next four quarters:

PNC Financial 130%

J.P. Morgan Chase 116%

Citigroup 109%

U.S. Bancorp 106%

Wells Fargo 104%

Bank of America 90%

The most common question my clients ask is “How do we know when we have enough in the ALL?” The answer in many respects will be proven with the benefit of 20/20 hindsight and will reflect a condition where current year charge-offs are less than the prior-year ALL balance, and when auditors and examiners will focus their attention to other matters of importance.